Sept. 17 (Bloomberg) -- Estonia must bring its budget gap within the European Union’s threshold this year if the Baltic state is to keep its 2011 euro goal and can’t assume the bloc will relax its rules, Standard & Poor’s said.

The EU “will be tougher than ever in terms of applying the criteria for membership,” S&P credit analyst Jean-Michel Six said in an interview in London. “They certainly don’t want to give the impression that they are relaxing those criteria.”

The EU and the European Central Bank have resisted calls from some eastern members to relax conditions for euro entry as the emerging states struggle to restore confidence in their currencies and get through the worst of the financial turmoil. Estonia is trying to cut this year’s budget deficit by more than 7.6 percent of gross domestic product, to the detriment of economic growth, to keep the gap at last year’s 3 percent.

“It will only become clear over the next couple of months whether or not Estonia meets the budgetary target,” S&P credit analyst Frank Gill said in an interview. “It’s a close call.”

The budget cuts are exacerbating the country’s recession, which is the third-deepest in the EU after Lithuania and Latvia. Prime Minister Andrus Ansip is betting the switch to the euro will attract new investment to fuel economic growth and boost trade by eliminating currency risk for companies.

CDS

Estonia doesn’t have a sovereign bond market, though a credit default swap market on the country’s debt exists. CDS spreads on five-year Estonian debt fell 2.5 basis points to 217.5, according to CMA DataVision prices at 1:10 p.m. in London. The country’s CDS spreads peaked at 737 basis points on Feb. 17, according to Bloomberg. The narrowing spread signals growing investor confidence.

The country’s central bank says reaching the EU’s budget target this year isn’t a given, though the lender of last resort interprets the EU’s Stability and Growth Pact as allowing for some flexibility.

“Estonia certainly can’t bet on it, but needs to achieve the conditions foreseen by the Maastricht budget deficit criterion,” central bank spokesman Viljar Raask said in an e- mailed response to questions.

The EU’s Excessive Deficit Procedure “may not be launched if the deficit remains close to the 3 percent threshold, it is considered temporary and exceptional, as in case of a deep recession, and if the country reduces the deficit below 3 percent of GDP the next year,” Raask said.

Euro Pegs

All three Baltic states peg their currencies to the euro. Lithuania hasn’t set an official target for adopting the single currency, while Latvia, which is relying on an International Monetary Fund and EU-led loan to avert default, expects to join the currency bloc in 2014.

Latvia’s economic crisis prompted speculation the government may devalue the lats, as delays in committing to budget cuts that complied with the terms of its international bailout held back disbursement of the loan.

Lithuania’s bid to adopt the euro was rejected in 2006 even after the country met the bloc’s economic conditions. EU officials defended the decision on the grounds that they expected inflation to accelerate.

According to S&P, the EU is unlikely to bend its euro rules to prevent regional currency crises.

“The ECB doesn’t consider itself as the emergency ward for countries running into difficulties obtaining international financing,” Six said. Willingness to accept new members also “depends on the overall improvement of the economic conditions in the euro zone in a very convincing and sustained way.”

Users of the common currency are opposed to fast-tracking the eastern states toward euro use. Euro-area finance ministers in March rejected the idea of easing the process.

Credit Rating

If Estonia manages to keep its budget within the EU’s 3 percent threshold, its creditworthiness will improve, Six said. A budget gap of 3 percent or less means “Estonia would almost certainly be eligible to enter EMU at the beginning of 2011,” Gill said.

S&P on Aug. 11 lowered Estonia’s long-term credit rating to A-, the fourth-lowest investment grade, on concern the country’s efforts to lower reliance on external financing may delay euro adoption.

The January 2011 euro-adoption goal is “clearly achievable” and is key to maintaining investor confidence, central bank Governor Andres Lipstok said on Sept. 7.

GDP will shrink 14.5 percent this year, the government estimated last month. The Finance Ministry said the budget shortfall has to be narrowed by another 2.5 billion krooni ($228 million) this year and 4.5 billion krooni in 2010, on top of cuts of more than 16 billion krooni so far.

Greece

The European Commission in 2004, when the bloc absorbed eight former communist states, tried to censure Germany and France after the euro region’s two largest members breached the 3 percent budget deficit rule. The two countries obtained European Council backing to reject the censure, though the commission then brought the council to court and won the case.

In November that year it emerged that Greece had misled the EU about the health of its fiscal stance when it joined the euro four years earlier. The episode sparked a debate on the fairness and credibility of the bloc’s fiscal rules.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

Last Updated: September 17, 2009 08:43 EDT